BOND MARKETS

Covers government bonds and corporate bonds

GOVERNMENT BONDS
The instrument of government debt has evolved over the years. Government securities
were mainly fixed-interest-rate annuities, payable for the life of a named annuitant. They
were transferable, but transfer was difficult. Sale required a title search, much like that
required today for the sale of a house. To receive interest, the new owner had to furnish
proof that the annuitant was still alive.
To eliminate the need to prove an annuitant was still alive, governments began to issue
permanent annuities or perpetuities that could be sold or left in inheritance. The best
known perpetuities are the consols issued by the British government to consolidate the
debt of the Napoleonic wars. These securities are still traded today. In addition to
borrowing long-term to finance their deficits, governments sometimes need to borrow
short-term for liquidity reasons –to bridge temporary imbalances between tax receipts
and spending. The English government first issued such short-term government debt in
1696 in the form of an interest-bearing “exchequer bill”.

Governments have often tailored the instruments they issue to exploit successful existing
markets for private securities. One example is the issue of lottery loans to exploit the
popularity of private lotteries in the late eighteenth and early nineteenth centuries.
Another example is the treasury bill. This was created by the British treasury in 1877 at
the urging of Walter Bagehot, editor of the Economist. The T-bill is a discount instrument
intended to mimic the commercial bill. The idea was to tap the thriving London money
market that traded in commercial bills. The treasury bill proved enormously successful.
Not only did it replace exchequer bill as a source of short-term liquidity, but governments
soon began to roll over Treasury bills to fund their long-term borrowing.

Types of government debt

Most government securities are marketable (transferable), but some are not. original
purchasers of non-marketable debt cannot sell it to anyone else. They can redeem it
1
before maturity only from the Treasury itself. The best-known example is the U.S savings
bond, which is sold to households. Other non-marketable securities are sold to state and
local governments and to foreign governments.

Most government securities are issued by the Department of the Treasury. They are
known in the market as treasuries or governments. The shortest-maturity Treasuries are
3-, 6-, and 12 month T-bills. T-bills sell at a discount.
In addition to bills, the treasury offers coupon securities (called coupons by the market)
with maturities of from 2 to 30 years. Those with maturities of 2 years to 10 years are
called notes; those with longer maturities are called bonds. Coupons on these securities
are paid semi-annually. Notes and bonds may sell at par, at a discount, or at a premium,
depending on market interests’ rates.

The primary market

New issues of treasury securities are sold at auction. In the US, the auctions are organized
by the Federal Reserve Bank of New York. About one-half represents refinancing of old
debt: the money raised is used to pay off old issues that mature. The rest goes to finance
the current deficit. There are weekly auctions of bills and regular, mostly quarterly,
auctions of bills and regular, mostly quarterly, auction of notes and bonds.

Auction procedures
Any one wishing to buy part of a new issue (relates to US) must submit a sealed bid to
any one of the Federal Reserve Banks (most are submitted it the New York Fed) by the
stated deadline. There are two types of bid: competitive bids specify price; non-
competitive bids do not. The non-competitive bidders are usually less sophisticated small
investors. Competitive bidders are either dealers, who expect to resell the securities at a
profit, or institutional investors, who believe they can get the securities more cheaply by
bidding themselves than buying from a dealer. Any bid for more than $ 5 million of
securities must be competitive. No single competitor bidder may purchase more than
35% of a given issue. Successful competitive bidders pay the price they have bid; low
bids get nothing. This type of auction is generally called an English auction (except by

2
the English, who call it an American auction). Non competitive bids are all accepted at a
price that is a weighted average of those paid by successful competitive bidders.

How to bid
You can see the considerations involved in submitting a competitive bid. You want to bid
high enough to have your bid accepted, but not so high that you overpay. In this type of
auction having your bid accepted is not entirely good news: it may mean that you have
bid too high and that you will take a loss when you resell the securities. This paradox is
known as the winner’s curse.

The secondary market

While the primary market for governments may seem large, it is dwarfed by the
secondary market. The secondary market for governance securities is very liquid: bid-ask
spreads are small; the market is deep, routinely accommodating trades in the billions of
dollars.

How the secondary market is organized

The US secondary market for government securities is decentralized, over-the counter
dealer market. Information is carried on computer terminals, but actual trading takes
place over the telephone. The market operates 24 hours a day, worldwide. Although it has
no single physical location, it is centered in New York City. The principal participants are
dealers, brokers, and clearing banks.

Dealers make the market: they quote bid and ask prices at which they are willing to buy
and sell government securities. To back up their quoted prices, they must take a position
in securities. If someone wants to buy, dealers must have the securities available to sell; if
someone wants to sell, they must be ready to buy and to add the securities to their
inventory. There are two types of dealer – primary and secondary.

The global market for government securities

Cross-border trading in the secondary market has grown rapidly in recent years. In the
late 1980s, it was growing at the rate of 22% a year. Night time trading volume is
3
currently estimated at over $ 50 billion per night. Trading around the clock has created a
demand for support around the clock. It has led to off-hours trading in related derivative
securities in Chicago, London, and Tokyo. The Public Securities Association, the trade
organization of primary dealers and brokers, has plans to publish trading information
around the clock.

Increasing globalization of trading in U.S. government securities has put competitive

pressure on domestic markets for government securities in other countries. As investors
have found it easier to invest in the securities of foreign governments, domestic markets
have had to modernize or face a loss of business.

The evolution of the government securities market

Historically the earliest securities markets were markets for government securities.in
most countries even today, the markets for government securities remains the largest
security markets. The markets for the US government securities are by far the largest
securities Market in the world. Trading in US government securities goes on worldwide
and continues around the clock. Trading volume dwarfs that in any other securities
market. Trading among major dealers alone routinely exceeds $100billion a day,
compared to about $10,000 a day in on the New York Stock Exchange.

Markets for government securities are important not only for their size. Government
securities play a special role in the economy. The interest rate on the government
securities is the risk free rate against which all other interest rates are measured. In many
countries the central bank regulates the quantity of money buying and selling government
securities because this market is among the least regulated, it has been at the forefront of
innovation.

4
CORPORATE BONDS
A corporate bond is a long term borrowing by non-commercial bank firms from
investors. The firm obtains the capital it requires and in return the investor receives an
agreed number of interest payments at either a fixed or variable rate of interest and the
original investment on maturity. The bonds may be unsecured or secured. Some issues to
note include:
 A corporate bond is long term debt issued by a firm as a way of raising funds.
 An investor who buys a corporate bond lends to the firm in return for a series of
interest payments.
 Corporate bonds are actively traded on the secondary market.
 Corporate bonds are considered riskier than treasury bonds, and hence they tend
to have higher interest rates to compensate for this additional risk.
 The highest quality (and safest, lower yielding) bonds are commonly referred to
as "Triple-A" bonds, investment while the least creditworthy are termed "junk".

In the investment hierarchy, high-quality corporate bonds are considered a relatively safe
and conservative investment. Investors building balanced portfolios often add bonds in
order to offset riskier investments such as growth stocks. Over a lifetime, these investors
tend to add more bonds and fewer risky investments in order to safeguard their
accumulated capital. Retirees often invest a larger portion of their assets in bonds in order
to establish a reliable income supplement.

In general, corporate bonds are considered to have a higher risk than government bonds.
As a result, interest rates are then higher on corporate bonds, even for high credit quality
companies. The difference between the yields on highly-rated corporate bonds and
government bonds is referred to as credit spread.

Before being issued to investors, corporate bonds are reviewed for the creditworthiness of
the issuer by rating agencies, such as, Standard & Poor's Global Ratings, Moody's
Investor Services, and Fitch Ratings. Each has its own ranking system, but the highest-
rated bonds are commonly referred to as triple A rated bonds. The lowest rated corporate

5
bonds are called high-yield bonds due to their greater interest rate applied to compensate
for their higher risk. These are also known as junk bonds.  Bond ratings are vital to
alerting investors to the quality and stability of the bond in question. These ratings
consequently greatly influence interest rates, investment appetite, and bond pricing.

In the US, corporate bonds are issued in blocks of $1,000 in face or par value. Almost all
have a standard coupon payment structure. Typically a corporate issuer will enlist the
help of an investment bank to underwrite and market the bond offering to investors. The
investor receives regular interest payments from the issuer until the bond matures. At that
point, the investor reclaims the face value of the bond. The bonds may have a fixed
interest rate or a rate that floats according to the movements of a particular economic
indicator.

Corporate bonds sometimes have call options to allow for early prepayment if prevailing
interest rates change so dramatically that the company deems it can do better by issuing a
new bond. Investors may also opt to sell bonds before they mature. If a bond is sold, the
owner gets less than face value. The amount it is worth is determined primarily by the
number of payments that still are due before the bond matures. Investors may also gain
access to corporate bonds by investing in any number of bond-focused mutual funds or
ETFs.

Corporate bonds are a form of debt financing. They are a major source of capital for
many businesses, along with equity, bank loans, and lines of credit. They often are issued
to provide the ready cash for a particular project the company wants to undertake. Debt
financing is sometimes preferable to issuing stock (equity financing) because it is
typically cheaper for the borrowing firm and does not entail giving up any ownership
stake or control in the company.
Generally, a company needs to have consistent earnings potential to be able to offer debt
securities to the public at a favourable coupon rate. If a company's perceived credit
quality is higher, it can issue more debt at lower rates. When a corporation needs a very
short-term capital boost, it may sell commercial paper, which is similar to a bond but
typically matures in 270 days or less.
6
The difference between corporate bonds and stocks
An investor who buys a corporate bond is lending money to the company. An investor
who buys stock is buying an ownership share of the company. The value of a stock rises
and falls, and the investor's stake rises or falls with it. The investor may make money by
selling the stock when it reaches a higher price, or by collecting dividends paid by the
company, or both.

By investing in bonds, an investor is paid in interest rather than profits. The original
investment can only be at risk if the company collapses. One important difference is that
even a bankrupt company must pay its bondholders and other creditors first. Stock
owners may be reimbursed for their losses only after all of those debts are paid in full.
Companies may also issue convertible bonds, which are able to be turned into shares of
the company if certain conditions are met.